Welcome back to our stock valuation series! In our previous episode, we delved into the Dividend Discount Model (DDM) and its ability to estimate a stock's worth based on anticipated dividends. Today, we embark on a new chapter, where we will explore another widely-used valuation technique: the Discounted Cash Flow (DCF) Model. Join us as we unravel the pros of this comprehensive tool and address its limitations when dealing with companies that have harder-to-predict cash flows.
Understanding the DCF Model
The DCF model operates on the concept of the time value of money, considering both the inflow and outflow of cash within a company. While the DDM focuses on dividends, the DCF model offers a broader perspective by incorporating all future cash flows, not just those distributed as dividends. This makes it particularly suitable for companies that retain most of their earnings rather than paying them out to shareholders.
How to Use the DCF Model: The DCF model consists of three stages: forecasting future cash flows, calculating the terminal value, and aggregating these values to estimate the stock's present worth.
Stage One: Forecast Future Cash Flows "Free cash flow" is the amount of cash that a company brings in from its operations less the amount it has to spend maintaining those operations. You can usually find a firm’s historical cash flow data online or calculate it from financial statements. From there, you’ll need to estimate what future cash flows are likely to be for the next few years, based on your take on the company’s fundamentals.
Stage Two: Calculate the Terminal Value With any luck, your chosen company will exist for longer than a few years – so we also have to capture its value beyond your cash flow forecasts. We calculate this future “terminal value” using a perpetual growth model that assumes the company will keep expanding (slowly) forever.
Stage Three: Add it All Up To figure out what the stock’s worth today, you need to add the discounted value of each future cash flow to the company’s discounted terminal value. Then finally, divide by the number of shares.
Limitations of the DCF Model: The DCF model’s drawback is that it suits firms with predictable cash flows. But many businesses have cash flows that are much harder to predict. The discounted cash flow model attempts to estimate a stock’s value by capturing future incomings and outgoings. It works well when cash flows are predictable – but that’s often not the case.
Conclusion: The DCF model is a powerful tool for stock valuation, especially for companies that retain most of their earnings. However, it's important to remember that it's not a one-size-fits-all solution and requires careful consideration of a company's cash flows.